THE DANGERS OF USING ETFS IN EMERGING MARKETS

THE DANGERS OF USING ETFS IN EMERGING MARKETS

Ahead of my upcoming talk at the?Exchange Traded Funds Asia?event in Hong Kong, where I will be discussing whether?actively managed ETFs can outperform interest in traditional ETFs, here are seven resons why I believe managing money to a benchmark in the Emerging Markets (EM) is both mistaken and highly risky:

(1)?? Amidst the prospects of anaemic growth, long term fiscal deficits and currency weakness in the West, investors are beginning to realise that diversifying away from benchmarks is becoming essential. At Milltrust, we believe investors will look to the growth markets of?Brazil, Latin America, India, South East Asia, and China?for performance in their portfolios. To achieve this, allocators will need to depart from conventional benchmark weightings. Investors commonly use indices such as MSCI EM but these are often misrepresentative of the economic importance of their constituenteconomies. For example, the MSCI EM index only represents 13 percent of the world, an inappropriate weighting by any measure when taking into account that EM will probably account for 45-50 percent of global GDP this year. Consequently, institutions who allocate on an MSCI model will be massively underweight the economies that are the fastest growing and will remain so in the coming years and decades.

(2)???Over the years, ETFs have significantly replaced benchmark allocations as they offer index returns at basis point fees. They are of course indiscriminate and cause huge market distortions by purchasing the larger stocks regardless oftheir underlying valuations or corporate credentials (passive investors and benchmarking are open to similar criticism). In reality, investors are buying into an active manager charging fees for managing to a benchmark whilst creating little value at all. A plethora of research exists pointing to the fact that the majority of managers fail to beat their benchmark. For any investment professional, ETFs are typically dismissed as an attractive alternative for the lazy investor.

(3)?? The Hong Kong H Shares market is down 18 percent in the 1st half of the year. Given that this represents most international investors? exposure to China, any benchmarked investor will have lost a significant amount of their pension contribution, insurance premiums or hard earned savings as a consequence of simply investing in the benchmark. Claims of outperformance of a tumbling index is scant consolation.

Furthermore, any investor in the Brazilian Real will have faced a double whammy of losses from the currency reaching its lowest levels in the past 4 years, in addition to the sharp setbacks in the market. This is not solely because of the changing fortunes for the developed world nor the slowdown in China but, rather, from the short-term ?risk off? trade which is disproportionately impacting less sophisticated and thinner capital markets.

(4)?? Investing in an index can sometimes lead to large concentration risks and artificially high exposures to market segments that do not represent the underlying economy. An investment in the Brazilian index for instance wouldgive an investor exposure to Vale and Petrobras, two huge commodity stocks that are geared entirely to the international economy. They jointly represent about 40 percent of the market cap or the Brazilian Ibovespa, yet Brazilian GDP is driven largely by the domestic economy (95 percent of GDP) into which over 50 million people have moved over the past decade. Any investor in the index would have largely bypassed many of the tremendous success stories that only an active investor, prepared to depart from the index, would have accessed.

(5)?? I believe more and more investors have woken up to these shortfalls in the developing markets and that this is precipitating a shift away from the expensive benchmarkers that destroy investors’ capital which can take years to restore. As benchmarkers they are simply ill-equipped to assist investors in understanding when “to take risk off and when to put it back on again”. This is simply not part of their investment psyche.

Part of the bet we are making at Milltrust is that institutional investors will look to people like us who both work with regional powerhouses, and who can demonstrate some evidence of being able to protect capital during drawdowns, adding real alpha when the markets are rising.

(6)??Closet benchmarking warrants very low fees, but more so a readiness to accept volatile returns. In our view it is one of the reasons why most institutions have very small allocations to EMs.

(7)??As investors allocate more money to EM, they will focus more on the volatility of these markets. Consequently, they may not wish to have long-only exposure as these markets can experience regular bouts of strong volatility. Our structure is built around flexible managed accounts which permit the use ofindex hedging and portfolio flexibility. They are not run to the benchmark.

With renewed concern over many of the world’s largest issuers of ETFs and other passive investment instruments, we are safe in the knowledge each of our funds is housed on a single custody platform, run by the world’s largest custodian bank, and free from the contagion of an investment banking balance sheet. On a final note, managed accounts also protect you from the impact of other investors indiscriminately selling at exactly the wrong time, which is what appears to be happening just now, and which is a defining feature of index trackers.